Thursday, 10 January 2013

A finer balance

India's current account deficit has risen sharply to above 5 per cent of the GDP. Finance Minister P. Chidambaram is reported to have reacted to the balance of payment statistics by saying that he may have to increase the import duty on gold. If the solution to the country's balance of payment problems lay in high import duties, India would never have had the 1991 crisis.

Fortunately, in the July-September quarter, the previous finance minister's budget proposals on taxing foreign capital flows were not implemented, otherwise the balance of payment situation could have been much worse. The government should now conduct a stress test capturing the scenario of a sudden drop in foreign investment flows and its impact on the economy. This should form the basis of thinking about a policy framework in which the Indian economy would be resilient to such shocks.

The current account deficit in July-September 2012 stood at 5.4 per cent of GDP. Thanks to foreign investment inflows, both direct and portfolio, India did not witness a sharp depreciation of the rupee during this period. Depreciation would have made the already high inflation worse. It would have put a lot more businesses, already looking for debt restructuring, in greater difficulty. Portfolio inflows between July and September 2012 were $7.6 billion. In the same quarter of 2011, there was a net portfolio outflow of $1.4 billion. Suppose a similar swing takes place in the next quarter - what will be the impact on the economy?

Complacence on the part of policymakers would be a mistake. The total quantities of exports or imports are not determined by the government. Policies can only change incentives to buy or sell globally traded goods and services. If, due to a change in global conditions, there is a change in global financial flows, the current account deficit would be financed by trade credit or debt flows. This could potentially pave the way for a much bigger crisis. There would likely be greater pressure on the rupee to depreciate. The government would, in all probability, step in with a number of knee-jerk reactions to stop capital outflows, to prevent dollar borrowing, to push the RBI to intervene to prevent rupee depreciation, to first impose higher duty on gold and then post additional customs officers as well as have stringent checks at international ports and airports to prevent smuggling. Measures with origins dating back to the licence quota raj will be conjured up, with the hope that this time they would work.

The most important aspect of the recent BOP statistics is that the rise in the current account deficit is due to a decline in exports, not a sudden increase in imports. In fact, imports are lower as well. As the world economy has slowed down, so has export demand. Even with a relatively weak rupee, the effect of a slowdown in the US and Europe has reduced exports.

For now, service exports have held up. But if difficulties in the West continue, it is hard to see how Indian exports can keep growing. We certainly should not have policy frameworks that avoid a crisis only in the very optimistic scenario of Indian exports growing fast or foreign investment flowing to India, despite all the turmoil in global markets. Today, that is our policy framework for the external sector. How will a fall in exports, a depreciation of the rupee, a sudden stopping of foreign investment affect our balance of payments? To make the economy resilient in the face of lower export demand and in the event of a fall in foreign investment flows, we need to ask whether our policies make imports elastic as well.

Imports of gold, silver, precious stones and gems, mainly used in jewellery exports, fell in July-September 2012. Other imports, meant for domestic consumption, however, continued to grow. If we believe that demand responds to changes in prices, as we seem to in the case of gold, we should think about our bizarre policy of subsidising imported goods and making them cheaper. Our biggest import, petroleum, and its products, such as diesel, kerosene and urea, are sold to consumers at subsidised rates, encouraging consumption of these products. Exchange rate changes to these products are passed on slowly as the government fixes diesel prices in rupee terms and changes in administered prices are made only after huge delays. If market prices had prevailed, a fall in exports would have led to a rupee depreciation. This would have pushed up the price of imported oil and, at least in the long run, reduced consumption.

Subsidising imports is different from subsidising a domestically produced non-tradable service like education. If the expenditure is financed by borrowing, not only does it push up domestic demand, it does so for an import-intensive good. This was not an issue in the first decade of the 2000s, when Indian exports were growing rapidly. The main focus of the debate in the context of the oil subsidy was the large subsidy bill, the fiscal deficit, the price distortion, the leakages, the adulteration of diesel with cheaper kerosene and so on. But now that the current account deficit has risen to more than 5 per cent of the GDP, we need to think about oil subsidies in terms of the impact they have on the current account deficit as well.

For many years, economists have been crying themselves hoarse about the dangers of a large fiscal deficit. They have warned that large deficits may lead to higher demand, resulting in inflation, and spill over into a current account deficit. But the Indian economy seemed to defy this logic. As the world economy did well, exports, both merchandise and service, grew rapidly. At the same time, as India's financial integration increased, dollars came into the capital account, financing our trade deficits. So, not only was the current account not very large, usually between 2 to 3 per cent of the GDP, the dollar flows kept it easily financed and there was no crisis. But this time may be different.